How to Position for Volatility Using Factors

In terms of the news cycle, 2017 was a volatile year. Yet you wouldn’t think that by looking at the equity markets: The Chicago Board Options Exchange Volatility Index (VIX) averaged a paltry 11.09 in 2017, well below a long-term average reading of 19.37. In addition, the VIX hit an all-time low of 9.14 this past November, depths untouched in the 25-year history of the “fear gauge.”

Will volatility remain low in 2018 or is the recent market selloff a harbinger of things to come? While the outlook is uncertain, equity investors seeking to remain in the market while positioning their portfolios for higher volatility can increase exposure to certain factors – like quality and low volatility – that tend to outperform the market and other factors when the VIX is rising.

Is the Stage Set for Higher Volatility?

The economic backdrop – which includes a synchronized global recovery and well-telegraphed U.S. Federal Reserve policy steps – offers insight into the drivers of 2017’s low VIX readings. Circumstances combined for global equity markets to post positive returns in every month of the year, with significant down days few and far between.

But investors would be unwise to expect similarly subdued levels of market activity in 2018. The Fed is targeting three more rate hikes, which may be well telegraphed, but could cause market fluctuations to increase.1 Corporate earnings are expected to continue their uptrend, but tax reform may increase the gap between winners and losers. Lastly, while Sir Isaac Newton stated that what goes up must come down, when it comes to the VIX in 2018, it may be the opposite – what goes down may go up. Between 1981 and 2016, the S&P 500 Index averaged a greater than 14% intra-year price decline – even the most bullish participants would agree that we are overdue for a correction.2

A Historical Analysis of Higher VIX Levels and Factor Strategies

Investors who anticipate market turbulence tend to race into safe-haven assets, such as cash. Equity investors who want to remain invested can allocate among factors to buffer their portfolios in times of volatility.

Looking at how factors performed during volatile periods in the past yields clues about what investors tend to favor during these times. To understand the relationship between spikes in volatility and factor performance, we analyzed the performance of factors during 1-month periods in which the VIX’s average daily rate of change was highest. We identified nine such periods since 2001, including episodes such as 9/11, the Global Financial Crisis, and the Flash Crash. Exhibit 1.

Observing average factor excess returns during these periods can reveal performance trends. Exhibit 2. As one may expect, yield and low volatility are the two strongest performing factors, with average excess returns hovering near 3% over the Russell 1000 Index. It seems that, when the market experiences significant gyrations, investors prefer the safety and security of higher-dividend-paying stocks and the predictability and steadier return streams of lower-volatility stocks. Quality also tends to outperform during these periods. Quality companies tend to have healthier balance sheets than peers, as exhibited by their wider profit margins and lower leverage employed relative to other factors. Exhibit 3. These stronger fundamental metrics offer a greater balance sheet “cushion” to weather potential income losses that investors may see on the horizon.

Turning the page to underperforming factors, size stands out as a clear laggard. Companies with low market capitalizations tend to carry greater business cycle risk, and have less balance sheet and operational flexibility, than larger-cap peers. Smaller companies also tend to have much narrower profit margins than other factors, which can pose challenges in the face of reduced consumer confidence and a shifting market. Investors are more nervous about investing in these companies during choppy markets, and punish them accordingly.

Exhibit 4 looks at factor performance during each period. While the results generally support the trends described earlier, there are some notable exceptions. The macroeconomic environment during these selloffs may offer insight into why a particular equity factor did not behave as expected:

The value factor outperformed following the September 11 terrorist attacks. Value tends to be flat or a laggard relative to the market during the periods identified, because fundamental concerns, increased use of leverage, and lower profit margins often cause these companies to trade at relative discounts. In the early 2000s, however, risk associated with overpriced technology stocks intensified, and value stocks may have been seen as less risky, as their weaker fundamental characteristics were overshadowed by the unwinding of the dot-com bubble.

In mid-2015, the size factor outperformed the market by nearly 2%, bucking a factor performance trend. The likely reason is that investors avoided large multinational companies during this time because they feared a major slowdown within emerging markets, and China in particular. Smaller companies, which tend to generate more revenue at home, performed well.

With the VIX having hit new lows daily last year, it is natural to fall into a gambler’s fallacy of sorts, expecting greater price swings simply on the basis that “we are due.” Historical VIX averages and equity drawdowns per year suggest we could see volatility increase, but if synchronized levels of global growth persist and central bank policy is well telegraphed, we may continue along in this extremely gentle global price environment. Investors expecting the VIX to rise materially may be able to position their portfolios toward low volatility, quality, and yield-oriented stocks, based on the stronger fundamental characteristics of these companies. These same investors may want to shun smaller companies, as they come with less balance sheet flexibility to withstand an impending shift in consumer confidence.

Alternative weighting approaches (i.e., using factor weighting as a measure), while designed to enhance potential returns, may not produce the desired results.

Past performance is no guarantee of future results. Charts and graphs are provided for illustrative purposes only. Index returns shown may not represent the results of the actual trading of investable assets. Certain returns shown may reflect backtested performance. All performance presented prior to the index inception date is backtested performance. Backtested performance is not actual performance, but is hypothetical. The backtest calculations are based on the same methodology that was in effect when the index was officially launched. However, backtested data may reflect the application of the index methodology with the benefit of hindsight, and the historic calculations of an index may change from month to month based on revisions to the underlying economic data used in the calculation of the index

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OFI Global Asset Management (“OFI Global”) consists of OppenheimerFunds, Inc. and certain of its advisory subsidiaries, including OFI Global Asset Management, Inc., OFI Global Institutional Inc., OFI SteelPath Inc., OFI Global Trust Company, SNW Asset Management, LLC and OFI Advisors, LLC. The firm offers a full range of investment solutions across equity, fixed income and alternative asset classes. The views herein represent the opinions of OFI Global and are subject to change based on subsequent developments. They are not intended as investment advice or to predict or depict the performance of any investment. The material contained herein is not intended to provide, and should not be relied on for, investment, accounting, legal or tax advice. Further, this material does not constitute a recommendation to buy, sell, or hold any security. No offer or solicitation for the sale of any security or financial instrument is made hereby.

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